By Andrew Suzuka, CEO, Optimization Partners
You log into your bank account – and it looks like you just hit the lotto. The large project deposit payment you’ve been waiting for finally arrived, and for a moment, you start to dream about how it will change the face of our agency, from new hires, raises, possibly moving to a larger office, and more. It all seems possible, especially if you’re looking at your agency’s finances on a cash basis. To make the best decisions though, you need to remember, cash doesn’t matter.
I’m saying that because I’ve seen agency owners make really bad choices based on what’s in their bank account, instead of how much they really earned. They were overly focused on their cash profits, instead of analyzing their accrual-based finances.
What’s the Difference?
The most basic definition of a cash-based business would be that income and expenses are recognized when the money goes in/out of the bank. To further illustrate this example, see the following chart:
This example is showing a $500,000 project, all of which the client pre-paid in January. On a cash basis, January’s profits seem incredible, almost too good to be true. The truth is, it is. Assuming the project will take at least 4-months to complete, that $500,000 will need to stretch the duration of those months, covering expenses ranging from payroll, to freelancers, rent, travel, and much more. Looking at January on a cash-basis would not provide you with the full picture, and could lead to costly mistakes.
Accrual-based businesses manage their P&L slightly differently, which is by recognizing revenue and expenses in the month(s) when the work is performed and expenses are incurred. To better illustrate this example, see the following chart:
This example is showing the same $500,000 project as mentioned above, but on an accrual-basis. This means we spread the revenue across the months the work is being completed, along with the related expenses. Instead of a $500,000 gross profit on a cash-basis for January, we are now showing $62,500 gross profit on an accrual-basis for the same month. Your big decisions should be made off the latter (accrual) number, and not former (cash).
Why Is It Important?
Converting and more importantly maintaining accrual-based books is certainly more time-consuming, but it’s imperative in today’s agency environment, which is more project than retainer based with ongoing margin suppression. Yes, it’s more time-consuming to manage your finances this way, because it requires more intimate knowledge about your industry and business than a typical bookkeeper possesses. However, those insights will help you drive game-changing investment decisions, or equally important, surgical cost reductions, and set you on the path towards thriving than simply surviving.